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Gold Backwardation Explained

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Something big is brewing in the gold market. The increasing demand of physical delivery of bullion from the COMEX threatens to throw that futures exchange into default as nearly happened in Vietnam in September (only they changed the rules to avoid a default).Now, I suspect the COMEX would also change the delivery rules before letting itself run into a default situation, but that act alone... a sudden shift in policy that separates investors from their gold on an exchange with COMEX's visibility would, in my opinion, lead to the mother of all spot price rallies.

Please take some time to view this video, which summarizes the backwardation phenomenon a little (though they could have done a better job explaining it), and if you're hungry for a more detailed perspective, take a look at Professor Fekete's article excerpted below.

December 2, 2008, was a landmark in the saga of the collapsing international monetary system, yet it did not deserve to be reported in the press: gold went to backwardation for the first time ever in history. The facts are as follows: on December 2nd, at the Comex in New York, December gold futures (last delivery: December 31) were quoted at 1.98% discount to spot, while February gold futures (last delivery: February 27, 2009) were quoted at 0.14% discount to spot. (All percentages annualized.) The condition got worse on December 3rd, when the corresponding figures were 2% and 0.29%. This means that the gold basis has turned negative, and the condition of backwardation persisted for at least 48 hours. I am writing this in the wee hours of December 4th, when trading of gold futures has not yet started in New York.

According to the December 3rd Comex delivery report, there are 11,759 notices to take delivery. This represents 1.1759 million ounces of gold, while the Comex-approved warehouses hold 2.9 million ounces. Thus 40% of the total amount will have to be delivered by December 31st. Since not all the gold in the warehouses is available for delivery, Comex supply of gold falls far short of the demand at present rates. Futures markets in gold are breaking down. Paper gold is progressively being discredited.

Already there was a slight backwardation in gold at the expiry of a previous active contract month, but it never spilled over to the next active contract month, as it does now: backwardation in the December contract is spilling over to the February contract which at last reading was 0.36%. Silver is also in backwardation, with the discount on silver futures being about twice that on gold futures.

As those who attended my seminar on the gold basis in Canberra last month know, the gold basis is a pristine, incorruptible measure of trust, or the lack of it in case it turns negative, in paper money. Of course, it is too early to say whether gold has gone to permanent backwardation, or whether the condition will rectify itself (it probably will). Be that as it may, it does not matter. The fact that it has happened is the coup de grâce for the regime of irredeemable currency. It will bleed to death, maybe rather slowly, even if no other hits, blows, or shocks are dealt to the system. Very few people realize what is going on and, of course, official sources and the news media won’t be helpful to them to explain the significance of all this. I am trying to be helpful to the discriminating reader.

Gold going to permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as it has been for years: gold is not for sale at any price quoted in Zimbabwe currency, however high the quote is. To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion gold or coined gold. I dubbed this event that has cast its long shadow forward for many a year, the last contango in Washington ― contango being the name for the condition opposite to backwardation (namely, that of a positive basis), and Washington being the city where the Paper-mill of the Potomac, the Federal Reserve Board, is located. This is a tongue-in-cheek way of saying that the jig in Washington is up. The music has stopped on the players of ‘musical chairs’. Those who have no gold in hand are out of luck. They won’t get it now through the regular channels. If they want it, they will have to go to the black market.

I founded Gold Standard University Live (GSUL) two years ago and dedicated it to research of monetary issues that are pointedly ignored by universities, government think-tanks, and the financial press, centered around the question of long-term viability of the regime of irredeemable currency. Historical experiments with that type of currency were many but all of them, without exception, have ended in ignominious failure accompanied with great economic pain, unless the experiment was called off in good time and the authorities returned to monetary rectitude, that is, to a metallic monetary standard. It is also worth pointing out that the present experiment is unique in that all countries of the world indulge in it. Not one country is on a metallic monetary standard, under which the Treasury and the Central Bank are subject to the same contract law as ordinary citizens. They cannot issue irredeemable promises to pay and keep them in monetary circulation through a conspiracy known as check-kiting. Not one country will be spared from the fire and brimstone that once rained on the cities of Sodom and Gomorrah as a punishment of God for immoral behavior.

In all previous episodes there were some countries around that did not listen to the siren song and stayed on the gold standard. They could give a helping hand to the deviant ones, thus limiting economic pain. Today there are no such countries. If you want to be saved, you must be prepared to save yourself. You cannot understand the process whereby a fiat money system self-destructs without understanding the gold and silver basis. The Quantity Theory of Money does not provide an explanation, because deflation may well precede hyperinflation, as it appears to be the case right now.

For these reasons I placed the study of the gold and silver basis on the top of the list of research topics for GSUL. These can serve as an early warning system that will signal the beginning of the end. The end is approaching with the inevitability of the climax in a Greek tragedy, as the heroes and heroines are drawn to their own destruction. The present reactionary experiment with paper money is entering its death-throes. GSUL has had five sessions and could have established itself as an important, and even the only, source of information about this cataclysmic event: the confrontation of the Titanic (representing the international monetary system) with the iceberg (representing gold and its vanishing basis) as the latter is emerging from the fog too late to avoid collision.

Unfortunately, this was not meant to be: GSUL has to terminate its operations due to a decision made by Mr. Eric Sprott, of Sprott Asset Management, to terminate sponsoring GSUL, saying that “results do not justify the expense.”

I sincerely regret that our activities did not live up to the expectations of Mr. Sprott, but I am very proud of the fact that our research is still the only source of information on the vanishing gold basis and its corollary, the seizing up of the paper money system that threatens the world, as it does, with a Great Depression eclipsing that of the 1930’s.

Let me summarize the salient points of discussion during the last two sessions of GSUL for the benefit of those who wanted to attend but couldn’t. The gold basisis the difference between the futures and the cash price of gold. More precisely it is the price of the nearby active futures contract in the gold futures market minus the cash price of physical gold in the spot market. Historically it has been positive ever since gold futures trading started at the Winnipeg Commodity Exchange in 1972 (except for some rare hiccups at the triple-witching hour. Such deviations have been called ‘logistical’ in nature, having to do with the simultaneous expiry of gold futures and the put and call option contracts on them. In all these instances the anomaly of a negative basis resolved itself in a matter of a few hours.)

In the commodity futures markets the terminus technicus for a positive basis is contango; that for a negative one, backwardation. Contango implies the existence of a healthy supply of the commodity in the warehouses available for immediate delivery, while backwardation implies shortages and conjures up the scraping of the bottom of the barrel. The basis is limited on the upside by the carrying charges; but there is no limit on the downside as it can fall to any negative value (meaning that the cash price may exceed the futures price by any amount, however large).

Contango whereby the futures price of gold is quoted at a premium to the spot price is the normal condition for the gold market, and for a very good reason, too. The supply of monetary gold in the world is very large relatively speaking. Babbling about the ‘scarcity of gold’ reflects the opinion of uninformed or badly informed people. In terms of the ratio of stocks to flows the supply of gold is far and away greater than that of any commodity. Silver is second only to gold. It is this fact that makes the two of them the only monetary metals. The impact on the gold price of a discovery of an extremely rich gold field, or the coming on stream of an extremely rich gold mine, is minimal ― in view of the large existing stocks. Paradoxically, what makes gold valuable is not its scarcity but its relative abundance, which evokes that superb confidence in the steadiness of the value of gold that will not be decreased by a banner production year, nor can it be increased by withdrawing gold coins from circulation. For this reason there is no better fly-wheel regulator for the value of currency than gold. The same goes, albeit to a lesser degree, for silver.

Here is the fundamental difference between the monetary metal, gold, and other commodities. Backwardation will pull in stocks from the moon as it were, if need be. The cure for the backwardation of any commodity is more backwardation. For gold, there is no cure. Backwardation in gold is always and everywhere a monetary phenomenon: it is a reminder of the incurable pathology of paper money. It dramatizes the decay of the regime of irredeemable currency. It can only get worse. As confidence in the value of fiat money is a fragile thing, it will not get better. It depicts the paper dollar as Humpty Dumpty who sat on a wall and had a great fall and, now, “all the king’s horses and all the king’s men could not put Humpty Dumpty together again.” To paraphrase a proverb, give paper currency a bad name, you might as well scrap it.

Once entrenched, backwardation in gold means that the cancer of the dollar has reached its terminal stages. The progressively evaporating trust in the value of the irredeemable dollar can no longer be stopped.

Negative basis (backwardation) means that people controlling the supply of monetary gold cannot be persuaded to part with it, regardless of the bait. These people are no speculators. They are neither Scrooges nor Shylocks. They are highly capable businessmen with a conservative frame of mind. They are determined to preserve their capital come hell or high water, for saner times, so they can re-deploy it under a saner government and a saner monetary system. Their instrument is the ownership of monetary gold. They blithely ignore the siren song promising risk-free profits. Indeed, they could sell their physical gold in the spot market and buy it back at a discount in the futures market for delivery in 30 days. In any other commodity, traders controlling supply would jump at the opportunity. The lure of risk-free profits would be irresistible. Not so in the case of gold. Owners refuse to be coaxed out of their gold holdings, however large the bait may be. Why?

Well, they don’t believe that the physical gold will be there and available for delivery in 30 days’ time. They don’t want to be stuck with paper gold, which is useless for their purposes of capital preservation.

December 2 is a landmark, because before that date the monetary system could have been saved by opening the U.S. Mint to gold. Now, given the fact of gold backwardation, it is too late. The last chance to avoid disaster has been missed. The proverbial last straw has broken the back of the camel.

I have often been told that the U.S. Mint is already open to gold, witness the Eagle and Buffalo gold coins. But these issues were neither unlimited, nor were they coined free of seigniorage. They were sold at a premium over bullion content. They were a red herring, dropped to make people believe that gold coins can always be obtained from the U.S. Mint, and from other government mints of the world. However, as the experience of the past two or three months shows, one mint after another stopped taking orders for gold coins and suspended their gold operations. The reason is that the flow of gold to the mints has become erratic. It may dry up altogether. This shows that the foreboding has been evoked by the looming gold backwardation, way ahead of the event. Now the truth is out: you can no longer coax gold out of hiding with paper profits.

If the governments of the great trading nations had really wanted to save the world from a catastrophic collapse of world trade, then they should have opened their mints to gold. Now gold backwardation has caught up with us and shut down the free flow of gold in the system. This will have catastrophic consequences. Few people realize that the shutting down of the gold trade, which is what is happening, means the shutting down of world trade. This is a financial earthquake measuring ten on the Greenspan scale, with epicenter at the Comex in New York, where the Twin Towers of the World Trade Center once stood. It is no exaggeration to say that this event will trigger a tsunami wiping out the prosperity of the world.

This is a bad explaination and the way this is being reported is a bit misleading.

This is not the first time gold has been in backwardation in history, but it is the first time the futures curve for gold has completely entered into backwardation for the COMEX. The front-month contracts have briefly traded below spot prices a few times earlier this year. Several other financial forums I visit are filled with more gold bugs that are more on top of this than I am.

This is very interesting for gold because it puts additional pressure for gold dealers to lend gold. Who wants to do that?

Textbooks would consider the instance of backwardation as a bearish signal, but I think because of it's financial impotance in today's environment that it's more of a contrary indicator.

I have seen Mish's response, and I disagree with him entirely. The significance of backwardation does not stem from an assumption that backwardation will lead to default on the COMEX... his source gets the causality -- well -- backwards. The backwardation is a reflection of a perceived risk of COMEX default as physical delivery requests soak up more and more of the COMEX's warehoused bullion supply (presently at 40% of total supply just for December contracts alone). As a result of this partial run on the exchange's physical supply, investors value earlier month contracts more highly than those further out. Incidentally, I think this also suggests that those investors in turn, for example for January contracts, intend to take another significant chunk of COMEX's supply out of the vault.

Then, Mish really disappoints me when he recognizes that backwardations are very rare in the case of gold (and ignores the duration of this incidence as greater than during any other modern occurrence), but still dismisses the significance with a cursory and intellectually lazy ... "so what?". Not what I expect from him ... if you're going to debunk an article, the onus is on the debunker to offer contrary arguments, so the 'so what?' comment was to me entirely unconvincing. Besides, the 'so what' is that this backwardation is occurring at a time when the global financial system sits on a precipice and demand for physical bullion is at unprecedented levels. The so what is that we have a fundamentally compromised USD which values gold at 25% below its March high, while in every other major currency the metal has broken out to new highs. This in turn highlights how untenable the dollars present position is, and it is in my opinion a sudden reversal of the USD that speculators are acting upon as they prepare to take delivery of their bullion.

The dollar's rally creates the possibilty of a calamitous fall if any one major foreign hlder of our debt -- or worse yet a coordinated and necessarily sudden unloading of much of the asset base.

"The so what is that we have a fundamentally compromised USD which values gold at 25% below its March high, while in every other major currency the metal has broken out to new highs."

Another way to put that is that most major currencies have been sold off vs the USD and gold is just one of many commodities that is "worth" less in dollars and more in euros (etc) than it was a little while ago.

Why am I wrong? And while you're at it, why is this much ballyhooed backwardation due to anything more than a momentary crush of gold bugs demanding physical delivery from a system that isn't really set up to accomodate it?

The relative strength of the USD to date against the other heavily weighted USDX constituents is necessarily a temporary blip when considered in the context of the policy interventions ... the dollar rally is an anamoly. The fact that gold has broken out in other major currencies is an important indicator of global investment demand ... the prices for other commodities like base metals have NOT broken out to new highs in those currencies, and remain extremely depressed from their 2008 highs.

Your last statement is correct ... we just interpret the event differently. :)

Here is Professor Fekete's latest. Please note I am not adopting his views nor predictions as my own... so please don't ascribe these views to me. I am still absorbing much of what he has to say, but I do share his conviction that this sustained backwardation event in gold holds major consequences that have yet to materialize nor be understood by even the majority of gold investors.

I do also share his views on the likelihood of an eventual default of the bullion ETFs like GLD and SLV, and as such I have been recommnding that Fools unload those ETFs for some time. With 758 tonnes of gold in the "trust", it holds more gold than all but 7 of the nations of the world... I see his item #5 is quite likely if indeed we experience a systemic dissolution of trust in all types of paper assets. Since such a meltdown is generally at least one motivtion for people looking for a safe haven in gold, I try to steer people away from the ETFs.

I have also considered his item #3 a remote possibility for some time.

Again, I am not adopting his views as my own, but merely posting his pieces because I think at the very least they provide an interesting basis for further analysis.

I sure wish he would can the gold fever talk, though. I think that sort of language merely cements many peoples' presumptions about the stereotypical gold investor. I continue to resist being labeled a goldbug despite my obvious preference for the metal as an investment at this time. Even if none of what Mr. Fekete forecasts transpires, gold will still increase in value per USD as the impacts of the policy interventions are realized.

Antal E. Fekete

Gold Standard University Live

Here is an update on the backwardation in gold that started on December 2 at an annualized discount rate of 1.98% and 0.14% to spot in the December and February contracts. It continued and worsened on December 8, 9, and 10 as shown by the corresponding rates widening to 3.5% and 0.65%. It is nothing short of awesome. This is a premonition of a coming gold fever of unprecedented dimensions that will overwhelm the world as soon as its significance is fully digested by the doubting Thomases. The worsening of backwardation must be viewed in the context of the gold price bouncing back from the lows of last week. It shows that the ‘gold bashing’ on Friday was done in the December contract. It is quite revealing that the spot price bounced back more than the futures price. The bulls are on the warpath. They have unearthed the hatchet. They have stopped eating from the hands of the clearing members.

Mish Shedlock published a disdainful criticism of my theory on the worsening backwardation in gold, calling it “nonsense” (see References below). A friend of his owns a seat on Nymex (a branch of Comex) who had this to say:

I have seen countless commodities go into backwardation for numerous reasons, the most frequent being a radical temporary divergence between immediate and overall demand. I have seen backwardations that have lasted years. The article is based on the assumption that a backwardation will necessarily lead to a breakdown of the delivery mechanism. But for every breakdown of the deliverymechanism there have been thousands of backwardations without a breakdown. Only if and when an actual breakdown occurred would the conclusions that the author drew make sense.

Well, well, one can buy himself a seat on the Nymex for sure, and the price is hefty these days, but Nymex does not deliver the understanding of monetary science along with the seat. Nor does any university anywhere in the world. To fill this obvious gap, I founded Gold Standard University Live. It is defunct today, but not because my theories are “nonsensical”.

It is defunct because Mr. Eric Sprott of Sprott Asset Management withdrew his funding after only three sessions, saying that “results do not justify the expense”. Under these circumstances I do what I can to teach all those who want to learn, and pick the “forbidden fruits” of monetary science that have been blotted out from the curriculum ― and from the gold and silver pits of Nymex.

Mish says that “there is nothing special about backwardation, period. OK, they are rare in gold. So what?” Here is what. There is a difference between “rare” and “non-existent”. Backwardation in gold has been non-existent, and for a very good reason, too, as I have explained in my articles. (I also pointed out that there have been ‘hiccups’, or short-lived instances of backwardation. They were temporary ‘logistical’ bumps, always resolved within a day at most, and they never ever spilled over to the next actively traded delivery month.)

Mish needs to educate himself on the fundamental difference between a monetary and a non-monetary commodity, before he can grasp the idea that lasting backwardation in gold is tantamount to the realization that ‘gold is no longer for sale at any price’.

The bottom line is that there is no fever like gold fever. It is akin to St. Vitus’ dance that swept through the Christian world just before the year 1000 A.D. affecting all the people who expected the end of the world to happen at the turn of the millennium. It was far worse than the mania that swept through the world affecting all the people who expected the 2K disaster to happen a thousand years later. The coming gold fever must be distinguished from tulipomania in February 1637, when one single tulip fetched the equivalent of 20 times the annual income of a skilled worker. Gold fever is as different from a bubble as real gold is from fools’ gold. It is visceral. It has to do with one’s instinct for survival. It has no patience with logical arguments. It is highly contagious, ultimately affecting everybody. A bubble that never pops.

You may ridicule the idea that, during a prolonged backwardation, all offers to sell gold will be withdrawn. But a serious analyst must answer the question why hundreds of millions of people having gold coins under the mattress and in the cookie jar refuse to take the bait of ‘risk-free’ profits offered by backwardation. Such a thing would never ever happen to a non-monetary commodity.

The only successful corners in history were gold corners, a.k.a. hyperinflation. Keynesian and Friedmaite economists in the pay of the government thought that gold futures trading will permanently short-circuit the forces of gold backwardation thus preventing hyper-inflation from ever happening. They were wrong.

In an article The Manipulation of Gold Prices (see References below), Professor Emeritus of Economics and former Dean of the School of Business Administration at the University of Indianapolis, James Conrad argues that Bernanke is different. He understands that he needs a much higher gold price in order to increase the efficiency of his airdrops. There is no better way to distribute new money among prospective spenders than putting it into the pockets of the gold bugs. (Conrad admits that he is one.) This will induce a large spending spree, holding deflationary pressures back.

According to Conrad, Bernanke is well aware that the new money he is feverishly airdropping has not stopped and will probably not stop the bloodbath in the stock market. Further devastation of share prices will render pension funds insolvent. To prevent this, the dollar needs a massive devaluation, on the pattern of Roosevelt’s tinkering with the value of gold. I quote:

Anyone who reads the written works of our Fed Chairman will know that Bernanke’s long term plan involves devaluing the dollar against gold. This is the exact opposite of the position of most prior chairmen. He has overtly stated his intentions toward gold, many times, in various articles, speeches and treatises written before he became Fed Chairman. He often extols the virtues of F. D. Roosevelt’s gold revaluation/dollar devaluation back in 1934, and credits it with saving the nation from the Great Depression. According to Bernanke, devaluation of the dollar against gold was so effective in stimulating economic activity that the stock market rose sharply in 1934, immediately thereafter. That is something that the Fed wants to see happen again.

It is only a matter of time before gold is allowed to rise to its natural level. Assuming that about one half of the recent increase in Federal Reserve credit is neutralized, the monetized value of gold should be allowed to rise to between $7,500 and $9,000 per ounce as the world goes back to some type of a gold standard. In the nearer term, gold will rise to about $2,000 per ounce as the Fed abandons its hopeless campaign to support Comex short sellers in favor of saving the other, more productive, functions of various banks and insurers.

Revaluation of gold, and a return to a gold standard, is the only way that hyperinflation can be avoided while large numbers of paper currency units are released into the economy. This is because most of the rise in prices can be filtered into gold. As the asset value of gold rises, it will soak up excess dollars, euros, pounds, etc., while the appearance of an increased number of currency units will stimulate investor psychology; and lending and economic output will increase all over the world. Ben Bernanke and the other members of the FOMC Committee must know this, because it is basic economics.

It is to be regretted that more of Professor Conrad’s admirable paper cannot be quoted here because of lack of space. To summarize: Bernanke is prepared to throw the issuers of paper gold at the Comex to the wolves, as they have become useless, even a nuisance, by now. Besides, the wolves must be appeased lest they devour whatever remains of the U.S. banking and insurance system.

My own position is somewhat different from Professor Conrad’s. In my view we are facing a world-wide elemental grass-root movement: the flight into physical gold ― witness the backwardation in gold. It is irresistible, and will ultimately overtake all other market forces. It will overwhelm official resistance.

An intriguing case can be made, as is attempted by Conrad, that Bernanke is intelligent enough to realize all this thinking that he can harness, if not hijack, the grass-root movement for his own purposes. This is a wee-bit more intelligence than I can give credit for to the Chairman, who is a former academic himself. I find the thought surrealistic that Bernanke wants to use gold as the safety-valve through which he can release steam from an overheating deflation one day, and from an overheating inflation the next.

Be that as it may, the Brave New World of irredeemable currency sans the paper gold factory at Comex will be an entirely different world from what we have been used to for the past thirty-six years. I highlight the differences as I see them. This should be helpful in the long run, even if this backwardation is temporary and gold futures trading will return to normal, since permanent backwardation is ultimately unavoidable.

Item 1: Barrick and other gold producers that still have an open hedge book will go bankrupt.

Item 3: Junior gold mines will put off starting production indefinitely. They will consider their gold ore reserves in the ground a safer store of value than paper money in an insolvent bank.

Item 4: The closing of the gold window at the Comex will furnish an excuse for other issuers of paper gold including the bullion banks to declare bankruptcy fraudulently.

Item 5: GLD and other joint depositories of gold will be under enormous pressure to default and let the owners of the ETF shares hold the bag. Let them sue for the gold. They won’t get it: their contracts give them no right to physical gold. They will get small change, in paper. The principals will cut up the gold pie among themselves. No crumbs will trickle down to shareholders.

Item 6: Even allocated and segregated metal account gold is not safe. The temptation on the account providers to default will be irresistible. They are not going to release the gold until expressly ordered by the courts, and will make sure that no gold will be left by then.

Item 7: Central banks forfeit their gold under leases due to backwardation, causing an uproar of citizens whose patrimony was sequestered and dissipated in such an ignominious manner.

Item 8: The only market for gold will be the fragmented black markets in various countries each charging a price whatever the traffic can bear. All legal protection of the ownership of and trade in gold will be suspended. The Dark Age will descend on the trading world, just as it did when the Roman Empire collapsed.

Our present experiment with irredeemable currency can last only as long as it is able to support futures markets in gold. The declining gold basis is the hour glass: when it runs out and the last grain of sand drops, gold fever will bleed the futures markets of cash gold, and the days of the regime of irredeemable currency are numbered.

Previous episodes of experimentation lasted no more than 18 years, or half as long as the present one which has taken 36 years so far, a world record. Of course, none of the earlier episodes were supported by futures markets. Forewarned, forearmed. Get ready and move closer to the doors. When the curtain falls on the last contango in Washington, there will be panic and some people may get trampled to death at the exit.

Dear Mish, lower your gun. The topic of gold backwardation is not for you.

I never thought I'd see the day that gold markets went into backwardation (spot prices higher than futures prices). However, the seemingly unthinkable has indeed happened. Of course, I'm not suggesting that backwardation will be a permanent feature of the market, as the misalignment of interest rates that theoretically caused gold backwardation is most likely not a permanent feature, either. Nonetheless, the question remains: Where do we go from here? This writer speculates that gold could very well turn out to be in a win-win situation, whether there is deflation or inflation. How is this possible? Adam Smith told us that gold is a barbaric relic, although it is more commonly known as the metal of kings. I remind you all that the world is still full of barbarians.

The above-ground stocks of gold, presumably available for disinvestment at any time, are some 60-fold of annual production of about 2,500 metric tons. This is why gold has never been in backwardation. Unlike any other commodity, all gold that has been mined throughout the ages is still out there somewhere. At an estimated 150,000 metric tons, this above-ground stock of gold--with most obvious portions in private hands or tucked away in central bank vaults--dwarfs annual production. Unlike industrial commodities such as copper, aluminum, or zinc, where prices can go into backwardation at the slightest hint of a temporary supply disruption from major producers, contango pricing has always been the norm for gold, where futures prices exceed the spot price.

Earlier this month, however, for the first time in history gold prices went into backwardation. Put differently, physical demand was to be met only by higher prices; those that held gold appear to be more reluctant to part with their hoard today than they may be in the future. Naturally, one wonders why it is that gold is now dearer in the face of what could turn out to be a potentially painful deflationary environment ahead.

Historically, it is understood that the role of gold is more of a hedge against inflation. Accordingly, the usual cadres of gold bugs have been telling us that gold strength reflects the enormous sums of money that are being printed and spent to bail out failing financial institutions and to shore up the flow of credit to prevent the economy from falling ever more deeply into recession. The inflationary implication of printing so much new fiat money is clear-cut to gold bugs; after all, Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. Most gold bugs equipped with charts showing money supply going through the roof see this as the precursor to runaway inflation ahead.

The flaw with that rationale, however, is that while it is true that money supply has increased significantly and inflation is a monetary phenomenon, it is the velocity of money that matters. And velocity has decelerated dramatically--a natural outcome of deleveraging. That's why I speculate that the deployment of monetary tools, including reducing the cost of credit through the Fed window to prevent deflation, is akin to pushing on a string. As long as the velocity of money is decelerating, one should expect that nominal economic growth will remain at best anemic worldwide, even if the cost of credit gravitates toward zero (and for all practical purposes is there already).

However, should the Fed decide to monetize debt, then inflation would become a threat. For now though, given the subdued velocity of money, swapping financial institutions' illiquid assets for liquid Treasuries to stimulate credit flow can hardly be viewed as inflationary, and it's not even having much success yet as financial institutions appear to be hoarding liquidity.

The last era of any significant period of deflation was in the 1930s. Although gold was fixed for a long time at $20.67 per ounce, in 1934 a massive devaluation of the U.S. dollar saw its fixed price jump to $35 per ounce. During this period of entrenched deflation, and in spite of the fixed price of the metal, gold proxies saw a dramatic rise in price. The NYSE-listed shares of Homestake Mining Company rose from about $4 to $500 from 1929 to 1935; the company operated for some 120 years until its flagship Homestake mine in Lead, S.D., ran out of economic reserves a few years ago and the company ceased to exist.

From my perspective, we dare not expect such returns from gold producers' shares, but I remain confident that our revised target price of $1,250 per ounce (our previous target of $1,000 was met) has a reasonable probability of panning out. That would likely result in handsome returns for gold producers' shares. The likes of Newmont Mining (NYSE:NEM - News), Barrick (NYSE:ABX - News), Anglogold Ashanti (NYSE:AU - News), Gold Fields (NYSE:GFI - News), and Agnico Eagle (NYSE:AEM - News) would benefit in such an environment.

That said, we could very well experience some deflationary forces first, before inflation (or more precisely, reflation) changes the course. Surely, a fast cure for deflation may simply be another major devaluation of the dollar, however unthinkable this may seem. Perhaps the following excerpt from Fed Chairman Ben Bernanke suffices as support for my take on gold prices:

"Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation."

Caveat emptor: This win-win proposition for gold is not for the faint of heart and is only speculation on my part. There is no reason to believe that the randomness of events will favor any one particular scenario. Only time will tell.